“Weakest Links”: March 2020 Was A Preview, Fragilities Are Now In Capital Markets And Liquidity Channels

By Marcel Kasumovich, Head of Research at One River Asset Management

Weakest Link I: Weak links lie within sectors and economies experiencing uninterrupted growth. Expectations are extrapolated from recent realities. Underwriting standards relax as growth hides risks. New Century Financial grew mortgage originations from $357mm in 1996 to $60bln in 2006. $1.2bln of capital. $17.4bln in credit lines. “CloseMore University” was the internal nickname. Originate. Sell. 60% dividend yield to discourage short-sellers. The sudden-stop in mortgage buying was the end of the line – the largest non-bank mortgage originator filed for bankruptcy April 2, 2007.

Weakest Link II: Weak links exist without systemic financial risks. Take Freeport-McMoRan (FCX). Emerging markets, China, and commodities recovered swiftly from the 2008 crisis. Strong free cashflow encouraged FCX to diversify into shale oil and gas just as China was tightening credit, sparking a global recession. The market put high odds on FCX default – long-term debt fell to 40 cents on the dollar. The company deleveraged. Terrible for shareholders. Today’s supply constraints are born from the underinvestment in those weak-link moments.

Weakest Link III: Commodities cratered in the 2015 downturn, expectations for terminal policy rates collapsed, and bond curves flattened. Long duration assets – broadly, like intellectual property – were the preferred investment. Buyouts surged: leverage companies with high free-cash-flow yields and use ‘cost synergies’ to deleverage. Even with rates low, those deals can be challenging. The Kraft-Heinz marriage in 2015 was funded by ballooning debt. But deleveraging was too slow. Shareholder value was destroyed. Another weak-link case study.

Weakest Link IV: The clues for the next crisis are usually found in the solutions to the previous one. The post-GFC macro megatrend was to issue more debt and less equity. Less equity is less principal risk. Less principal risk lends itself to weaker underwriting. That trade was funded through capital markets after the GFC, not by banks who were in a regulatory penalty box. Dealers now have less than one-tenth the credit inventory than 2007. Fragilities are now in capital markets and liquidity channels. March 2020 was a preview. Policy either accommodates or intervenes.

Weakest Link V: The leverage lending market – high yield bonds and leveraged loans – exploded to $3trln in 2021, double a decade earlier. Underwriting standards eroded. Covenants to protect creditors vanished. Opportunistic refinancing surge. But the tide is turning. JP Morgan took a $257mm write-down in Q2, stuck with loans they couldn’t move. Flexible pricing to discount unwanted loans is the new normal. Companies need to adjust – end buybacks, retain earnings. More principal risk. Fast or slow – excesses in leverage lending will be resolved.

Weakest Link VI: Debtor countries are driving inflation. Creditor countries are not immune. Inflation flips the narrative – US dollar reserves are a captive tax against creditors, savers. China gross national savings is 45% of GDP versus 18% for the United States. Chinese households flocked to what they could – physical assets are an extreme 69.3% of their wealth. Real estate dominates. Underwriting is weak. Highly indebted builders are funded by presale deposits. Credit downgrades are now rampant. Demographics are a severe headwind. Regional economies are unbalanced, fueled by coal. Political, financial, and environment threats are acute.

Weakest Link VII: The digital ecosystem is living its version of the GFC. Losses – some expected, many unforeseen – are being crystalized. It is small enough today with few direct linkages to the ‘real’ economy that digital is a spectator sport. But the areas of resiliency are the ones that can make the broader financial system stronger. Decentralized Autonomous Organizations brought risk-management changes to protocols at an unprecedented pace. It is for the public to see and learn from – its integration into the mainstream is part of the solution.